Highlights of
Report Number: 2007-30-172 to the
Internal Revenue Service Commissioners for the Small Business/Self-Employed and
Wage and Investment Divisions.

IMPACT ON TAXPAYERS

The practice
of deferring capital gains tax through like-kind exchanges is increasing in
popularity.However, if taxpayers do not
specifically follow the rules for like-kind exchanges, they could be held
liable for taxes, penalties, and interest on their transactions.Therefore, it is important for the Internal
Revenue Service (IRS) to provide specific and consistent guidance to taxpayers
on this provision of the tax law.

WHY TIGTA DID THE AUDIT

This
audit was initiated to evaluate the IRS’ oversight of the deferment of capital
gains tax through like-kind exchanges.TIGTA
also determined whether taxpayers’ use of this investment strategy is growing
and whether this poses any specific problems for the IRS.

Under
normal circumstances, when a taxpayer sells a business or investment property,
tax must be paid on the gain.A
like-kind exchange allows an exception to payment of the capital gains tax.When taxpayers sell businesses or investment
real estate and replace them with different businesses or investment properties
using an exchange, they can defer payment of the capital gains tax normally
required on these sales.As long as a property
used for business or investment is replaced with similar property, no gain or
loss is recognized at that time; rather, it is deferred until the eventual sale
of the replacement property.

A
taxpayer must report an exchange to the IRS on Like-Kind Exchanges (Form 8824),
which is filed with his or her tax return for the year during which the
exchange took place.The IRS Office of
Research, Analysis, and Statistics reported that in Tax Year 2004 taxpayers
filed more than 338,500 Forms 8824 claiming deferred gains (or losses) of more
than $73.6 billion.While this
represents a doubling of the number of like-kind exchanges reported in 1998,
the total dollar amounts deferred more than tripled.

WHAT
TIGTA FOUND

Like-kind
exchanges require more IRS oversight to ensure taxpayers comply with tax laws.Some IRS guidance to taxpayers needs revision
to provide more consistent and complete information regarding like-kind
exchange filing requirements.In
addition, the IRS regulations for like-kind exchanges of second and vacation
homes are complex and may be unclear to taxpayers, and little information exists
with respect to a published position by the IRS on like-kind exchanges
involving such properties.The absence
of clarification leaves unrebutted the sales pitch of like-kind exchange
promoters who may encourage taxpayers to improperly claim deferral of capital
gains through “tax-free” exchanges.

WHAT TIGTA RECOMMENDED

TIGTA
recommended the Director, Research, Small Business/Self-Employed Division,
conduct a study of issue-related returns selected by the National Research
Program.At the conclusion of the study,
the Research function would recommend to the Small Business/Self-Employed
Division Examination function what particular data should be captured in future
National Research Programs in order to ensure appropriate IRS oversight of
taxpayer compliance with tax laws pertaining to like-kind exchanges.TIGTA also recommended the Commissioner, Wage
and Investment Division, update some current guidance regarding
Form 8824 and provide additional guidance to taxpayers regarding the rules and
regulations governing like-kind exchanges of second and vacation homes that
were not used exclusively by owners.

In
their response to the report, IRS officials agreed with all of the
recommendations.The IRS plans to
conduct a research study of reporting and compliance issues associated with
like-kind exchanges and share the results with the appropriate function.In addition, the IRS agreed to revise
instructions for certain tax forms; update the information available on IRS.gov;
and provide additional guidance on like-kind exchanges to taxpayers,
practitioners, and stakeholders.

READ THE
FULL REPORT

To view the report,
including the scope, methodology, and full IRS response, go to: